How to draft a liquidated damages regime that will survive a challenge

Holly is a senior commercial lawyer who advises large Commonwealth Government agencies and private clients on major projects from inception and planning to implementation. Her experience covers contracting, funding and remediation activities.

A key benefit of a liquidated damages regime is that it gives both parties certainty about what happens if a contractual obligation is not met, such as failing to deliver goods by a certain date. However, it is often this contractual certainty that is challenged when it is time to pay damages.

There are some common challenges to a liquidated damages regime and key steps you can take to ensure your regime is enforceable.

Penalties

There has been a question mark over the enforceability of many commonly used contractual performance incentives since the High Court's decision in Andrews v Australia and New Zealand Banking Group Limited (Andrews).

Despite the uncertainty created by the Andrews decision, it appears that one principle remains clear—if the amount of the liquidated damages is a genuine pre-estimate of loss it will not be penal and, therefore, will be enforceable.

Prevention principle

The "prevention principle" operates to prevent a party claiming liquidated damages for the other party's failure to complete a task by a due date, where this failure was caused by the party claiming damages.

The principle is based on the notion that a party cannot recover damages for what they have caused.

Some common examples of acts of prevention include:

breach of contract, such as failing to give access or delaying granting approvals, or

valid actions, such as instructing the other party to perform additional works.

If your contract does not provide for how a delay is to be dealt with, the prevention principle will operate. This means that the party who was originally contracted to provide the goods or services in question is no longer required to do so by the original contractual deadline. In other words, the original deadline falls away and time becomes "at large", meaning that there is no longer a date for liquidated damages to start running from.

In the context of liquidated damages, the principle has been applied to disentitle a party from recovering liquidated damages even:

where the delay was caused by delays of both parties, or

if the other party, due to its own delays, could not have completed the work on time.

While time being "at large" does not necessarily mean that the party seeking damages is no longer entitled to any damages, it does mean that the party will have to establish what is a reasonable time for completion and the actual loss suffered as a result of the delay. Clearly this is more difficult and costly to establish than relying on the predetermined amount calculated under a liquidated damages regime.

How to overcome the effect of the prevention principle

A properly drafted extension of time regime can prevent a delay, caused by the party seeking to rely on the liquidated damages regime, resulting in time being "at large". An appropriately drafted extension of time clause allows the completion deadline to be extended by the same amount of time that the act of prevention delayed the contractor from performing its obligations. This effectively negates the effect of any delay caused by the party attempting to recover the liquidated damages.

Key points in drafting an appropriate extension of time clause include:

it is triggered by an act of prevention

there are strict notice requirements that the other party must comply with to obtain an extension of time, to avoid the party "banking" them and claiming extensions at the last minute

there is an ability to grant an extension of time unilaterally, to avoid the argument that the inability to claim an extension of time due to the notice provisions meant the prevention principle applies (as was held in Gaymark Investments Pty Ltd v Walter Construction Group Ltd), and

the ability to grant an extension of time can be exercised at any time, to ensure that if the matter is being determined after completion there can be a retrospective allocation of responsibility for delay.

What this means for agencies

Many standard form Commonwealth contracts include a liquidated damages regime. As with any standard form contracts, the danger in using many of the precedent clauses without fully considering their application is that there is a risk that, without tailoring for the specific circumstances of the transaction, the provisions may become unenforceable.

In the case of liquidated damages, it is critical that the contractual regime is not penal in nature and is flexible enough to respond to an act of prevention through an appropriate extension of time regime.

We would like to acknowledge the contribution of Ashley Cahif to this article.